Tuesday, June 19, 2012

Yesterday, I made a bullish case for equities over the long run (especially when compared to bonds), today I will outline one of the reasons I am a bit concerned over the intermediate time frame.

Meb Faber (via a paper by Mauboussin from Legg Mason) shows a table that outlines:

How companies have spent their cash over the past 25 years. Interesting to note is that they spend on average, about 60% of their total spend on capital expenditures, 20% on M&A, and about 10% each on dividends and executed buybacks. The total amount of spend bounces around a bit but is a fairly consistent 20% of market capitalization. Note that buybacks exceeded dividends in 7 out of the past 10 years

Along with the market cap of these corporations, the table shows (as part of a broader paper outlining the benefits and analysis of each) the amount corporations spent on:

Dividends

Share buybacks

M&A

Capital expenditures

I'll simplify things and group the first three as "financial expenditures" (or at least spending that isn't used for organic growth) and compare this figure with capital expenditures.

The first chart I'll show compares historical capital expenditures and financial expenditures, normalized as a percent of GDP. While Meb outlines the averages for each category above, what we see is financial expenditures have been trending higher while capital expenditures (as a percent of GDP) have been trending lower. This despite slower underlying economic growth (i.e. slowing growth of the denominator in the capital expenditure to GDP ratio), in part caused by a slowdown in (you guessed it)... capital expenditures. Some thoughts on why financial expenditures have increased in relative importance include the boom in private equity and financial engineering, the shorter-term focus of investors, and a lack of perceived opportunities to deploy cash on projects. Also note how volatile financial expenditures (mainly buybacks and M&A) have been.

The next chart shows the ratio between the two expenditures (financial expenditures divided by capital expenditures). In the late 1980's / early 1990's the ratio was consistently at or below 0.4 (meaning for every $1 spent on dividends, buybacks, and M&A they spent $2.5 on internal growth opportunities), whereas since the late 1990's the ratio has gone above 1 almost 50% of the time (i.e. corporations are now more interested in financial management then building their business through organic growth).

So what does this mean for an investor? Well, returned cash sounds good, but taking the above ratio and comparing it to the three year forward change in market cap (i.e. the value of corporations three years forward) we see a relatively strong (negative) relationship. Unfortunately (and not too surprising when you think about it), when corporations don't put money back into their businesses, the value of these corporations is negatively impacted (they are essentially liquidating vs reinvesting).

I'll leave with one additional point... this all likely reduces the impact of monetary policy (if a corporation is returning cash even at these low rates, why would they borrow more?).

4 comments:

Have you constructed this analysis with forward change in stock price (adjusted for dividends) rather than market cap?

It is intuitive that cash being taken out of a company decreases the total value of a company. The real question is whether investors are better off - do they have enough of an increased share of that company or have they received enough in dividends to compensate them for this decline?

It's actually the opposite... over this 25 year period buybacks & M&A activity tends to be larger during peaks of the equity market (why they are always deemed to have horrible market timing). As a result, in the years when market values are dropping (and the ratio is declining) these cash dispursements are declining too.

Definitely an important investment implication, but in my mind the more concerning thing is that financial cash management is negative for the longer term outlook for corporations. They can't grow faster than the broader economy for long (not mathematically possible), so we need reinvestment for economic and corporate growth.

There also may be some signaling effects in both directions. Firms disbursing more cash may be:1) Signalling they believe their stock is undervalued (unlikely given pro-cyclicality of buy backs)2) Signalling that they don't have any good prospects for earning above-WACC returns on reinvested capital

If you believe the latter, this could be another reason for subsequent underperformance.